In the recent ruckus kicked up by the Michael Lewis book Flash Boys, high-frequency trading firms found themselves accused of rigging equity markets by front-running investor orders.

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HFT techniques, however, are not confined to the trading of equities. In recent years, they have made increasing inroads into the currency markets, where there are allegations that they disrupt an orderly market. But they also provide liquidity to an industry that cannot afford to lose valuable marketmakers in the current environment.

In recent years, major FX trading platforms have been plagued by a series of disruptive practices such as placing orders without a genuine intention to trade or using multiple connections to exploit millisecond advantages when making trading decisions.

Whether HFT firms alone are responsible for such behaviour remains open to debate, but many trading platforms have taken steps to create a more level playing field. Their biggest challenge has been to control HFT without alienating it at a time when banks’ ability to provide liquidity is not always as strong as it was, given the regulatory constraints on proprietary trading and increasing capital requirements.

Some still view the FX markets as too cosy a monopoly owned by big banks such as Deutsche Bank, Citigroup, Barclays and UBS – collectively those four had just over 50% of global market share in 2013, according to an annual survey undertaken by Euromoney.

However, more nimble non-bank marketmakers such as Lucid Markets, GSA Capital and Virtu Financial pose a credible threat to that monopoly. Using ultra-fast technology, such firms can quote prices to trading platforms quicker than some of the largest banks.

But some consumers of FX liquidity complain that non-bank marketmakers are less committed than their bank competitors, which have longer records of liquidity provision and offer a wider range of services to clients, whereas HFTs may be more prone to flitting in and out of the market.

Paul Chappell, founder and chief investment officer of C-View, a UK-based currency hedge fund, said: “Non-banks really have less responsibility towards the market and its clients. If for a period of time it suits them to make markets, they will do so, but if volatility gets too high, they will effectively just switch off their machines.”

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It is a serious accusation that some HFT traders vehemently deny. GSA Capital says it provides liquidity in trade sizes of up to €50 million – larger than many banks – and it aims to differentiate itself by offering faster turnaround times and lower reject rates (in spot FX a marketmaker often has the ability, through a market convention known as “last look”, to reject a client order on a price it believes to be stale – a practice designed to protect slower marketmakers).

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Alex Gerko, head of FX trading at GSA Capital, said: “We have quoted FX prices continuously during stress events of recent years – throughout the 2010 Flash Crash and the aftermath of the Japanese earthquake in 2011, for example. Obviously, there may be some participants who do withdraw from the market in times of stress, but this is definitely not the case for GSA.”

Meanwhile, Virtu Financial has a similarly positive opinion of its contribution to the market, revealed in its S-1 filing, which was submitted to the US Securities and Exchange Commission on March 10 as part of a move to become publicly listed. Virtu stated: “We believe that marketmakers like us serve an important role in maintaining and improving the overall health and efficiency of the global capital markets by continuously posting bids and offers for financial instruments and thereby providing to market participants an efficient means to transfer risk.”

The firm’s net trading income last year was $624 million, the filing revealed, of which 20% came from making markets on FX trading venues.

But not all HFT firms adhere to the same rules. Virtu’s S-1 filing refers to the practice of “instantaneous hedging”, which is central to its marketmaking strategy and is designed to lock in returns and eliminate price risk by hedging positions at very fast speeds. At face value, the practice appears to be little more than prudent risk management, but not everyone sees it that way, with some complaining it is part of an accelerating race to compete on “latency” – the speed at which trading is done.

Gerko said: “Instantaneous hedging is technologically very complicated and very expensive due to the latency race, so most bank participants wouldn’t be able to do it. In the case of a large trade with multiple marketmakers, if an HFT firm aggressively and instantaneously hedges its position, while the other marketmakers sit on their position and hedge it more slowly and cheaply, they end up being effectively front-run by this single HFT marketmaker. The end-result is that the trade becomes more expensive for the end-client and it reflects badly on non-bank liquidity.”

Virtu Financial did not respond to requests for comment.

The battle between HFTs and traditional bank marketmakers has played out on the big trading platforms in recent years. Frustrated by the impact of disruptive behaviour on Icap’s EBS, one of the FX market’s primary interdealer platforms, a group of top-tier banks came together in 2010 to create their own venture. The resulting platform, ParFX, launched a year ago and is set to open up to the buyside this year, with a clear set of participation rules.

Dan Marcus, chief executive of ParFX at Tradition, the interdealer broker that provides the platform’s technology, said: “Traders need an environment where participants can trade with each other in a fair and transparent environment; where all firms – regardless of size, technological sophistication, financial clout or volumes traded – are treated equally and play by the same rules; where disruptive trading behaviour in any form is effectively policed and eradicated.”

Neither EBS nor Thomson Reuters Matching, its main rival, has been blind to the challenges created by HFT and both have engineered system and rule changes to create a more level playing field between participants. One of the more controversial has been a “latency floor” on EBS, which introduces a randomised batching window of between one and three milliseconds to all order elements. A similar feature exists on ParFX, while Thomson Reuters said in March it would also trial randomisation on the matching platform, initially for a single currency pair, as part of a broader set of rule changes.

The enhanced platform rules are intended to encourage genuine trading interest, high certainty of execution and a fair and orderly trading experience for all market participants.”

But some platform providers believe now is the time to embrace HFT as a source of liquidity rather than looking to stifle it. New York-based TraderTools offers disclosed relationship-based liquidity in the FX market, matching price-makers with takers, but it does not charge marketmaking banks, in contrast to many other platforms that charge both sides to participate. In recent months, TraderTools has begun streaming an increasing volume of non-bank liquidity, especially in emerging market pairs.

Yaacov Heidingsfeld, chief executive of TraderTools, said: “The reason we need non-bank flow is that the top marketmaking banks often don’t want to provide prices in emerging market currencies into those markets because they believe the regional banks in those markets will be advantaged by the information they have. But HFT firms can move in and out of markets much faster and we see a much greater willingness from those participants to make markets where traditional banks cannot.”

Furthermore, the presence of high-frequency trading flow is becoming increasingly vital for liquidity in some emerging markets, Heidingsfeld added.
“When trading in EM currencies was very volatile in January, particularly in the Turkish lira and South African rand, it would have been a lot more difficult to trade were it not for the presence of HFTs making markets.”

This article was first published in the print edition of Financial News dated May 5, 2014